Star Stock Picker Warns Small Caps Richly Valued

T. Rowe Price Group portfolio manager Henry Ellenbogen said last year’s rally in shares of companies with diminutive market values—or so-called “small-caps”—has put these stocks “at levels that may raise a caution flag.” The comments were made in his recently released annual report.

Mr. Ellenbogen’s $15.8 billion New Horizons Fund is the U.S.’s largest actively managed small-cap mutual fund, according to Morningstar.

“Based on several measures, small-cap valuations relative to historical ranges also remain elevated compared with large-caps,” Mr. Ellenbogen wrote. He added, “smaller-cap companies will have a difficult time outperforming larger-cap shares” as “larger-cap stocks offer better relative value in the near term.”

The Russell 2000 index of small-cap stocks returned 39% in 2013, handily outpacing the broader market.

The New Horizons fund, meanwhile, returned 49%, helped by its pre-initial public offering bets on Twitter Inc. and online retailer Zulily Inc.—which both went public last year—as well as holdings in Netflix Inc. and cancer drug maker Incyte Corp.

But those gains helped power an increase in the New Horizon’s fund’s price-to-earnings ratio to 32.6 at the end of December, the higher quarter-end level in more than 10 years, according to the shareholder level.

To that end, he seeks companies that can go through a “second act,” adding a new market or product, and develop into a steady long-term grower even after the hype has faded. The strategy involves holding on to some stocks for much longer than many small-cap managers would. For example, Regeneron Pharmaceuticals Inc., a major holding of the fund, has a market cap of $33 billion, according to FactSet—making it much bigger than what most would consider a “small-cap.”

Given that valuations have elevated, stock pickers are poised to have their mettle tested this year. But investors looking to jump on Mr. Ellenbogen’s bandwagon will have to wait. The fund was closed to new investments at the end of the year, amid a spate of similar moves by other small-cap mutual funds.

Last year saw 21 U.S. small-cap mutual funds close to new investors, the most in any year since at least 2001, according to Morningstar. Price appreciation and inflows of investor cash has made some of these funds big enough that managers have worried about them becoming ungainly.